Question

Exercise 10-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income [LO10-1, LO10-2]

Selected sales and operating data for three divisions of different structural engineering firms are given as follows:

	Division A			Division B			Division C
Sales	$	12,000,000		$	14,000,000		$	25,000,000
Average operating assets	$	3,000,000		$	7,000,000		$	5,000,000
Net operating income	$	600,000		$	560,000		$	800,000
Minimum required rate of return		14	%		10	%		16	%

Required:

1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover.

2. Compute the residual income (loss) for each division.

3. Assume that each division is presented with an investment opportunity that would yield a 15% rate of return.

a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity?

b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Answer 1

1
Margin = Net operating income/Sales
Turnover = Sales/Operating assets
ROI = Margin*Turnover
	Margin	Turnover	ROI
Division A	5.00%	4.00	20.00%
Division B	4.00%	2.00	8.00%
Division C	3.20%	5.00	16.00%
2
	Division A	Division B	Division C
Average Operating assets	3000000	7000000	5000000
Required rate of return	14%	10%	16%
Required operating income	420000	700000	800000
Actual Net operating income	600000	560000	800000
Required operating income	420000	700000	800000
Residual income(loss)	180000	(140000)	0
3a
Division A	Reject	As ROI exceeds 15%
Division B	Accept	As ROI is less than 15%
Division C	Reject	As ROI exceeds 15%
3b
Division A	Accept	As Minimum required return is less than 15%
Division B	Accept	As Minimum required return is less than 15%
Division C	Reject	As Minimum required return exceeds 15%
Workings for 1:
	Margin	Turnover
Division A	=600000/12000000	=12000000/3000000
Division B	=560000/14000000	=14000000/7000000
Division C	=800000/25000000	=25000000/5000000